SEC's crowdfunding proposal: Will it work for small businesses?

James L. Rench is a partner in Stark & Knoll's Business Services Group. He practices in general corporate, corporate transactions and commercial lending, and has been advising on mergers and acquisitions for more than 35 years.

On Jan. 16, the Small Business Subcommittee on Investigations, Oversight and Regulations of the U.S House of Representatives, led by Rep. David Schweikert (R-Ariz.), held a hearing with the above title to examine the job- creating impact of crowdfunding and how the related proposed rules of the Securities and Exchange Commission are expected to affect both the crowdfunding model and small businesses seeking to use it to access capital.The witnesses at the hearing represented a diversity of views on the subject and included a law professor and former SEC attorney, a representative of the Milken Institute think tank and several representatives of the crowdfunding industry.While the recommendations from the witnesses' testimony were many and varied, there was general agreement: There remain many opportunities to strengthen and improve the proposed rules.It is up to the SEC to continue working with the public and the financial industry as it finalizes the rules to determine the best actions for accelerating economic growth and creating jobs.The essence of crowdfunding is that it should be open to all investors regardless of income or net worth and that it will be conducted online through a platform that provides investors with a forum to shape and disseminate “the wisdom of the crowd” regarding the offering and its prospects. It is against this backdrop that several very sensible suggested modifications to the proposed rules have emerged.First and more generally, the final rules should minimize the costs associated with crowdfunding while simultaneously limiting downside risk to investors. This should allow for the development of this new market innovation and permit issuers, platforms and investors to evaluate the probity of the “wisdom of the crowd” thesis. Limiting downside risk to investors can be enhanced by increased emphasis on investor caps (i.e., the percentage of income an investor may put into crowdfunding in a year). This should be coupled with increased risk warnings and emphasis on adhering to the caps by the investors. Emphasis should be placed on compliance with the caps and penalizing noncompliance.The SEC should reduce disclosure requirements to those that are mandated by the JOBS Act in order to decrease costs and allow development of crowd-driven vetting mechanisms and criteria. Boilerplate disclosure documents not even reviewed by the SEC may give investors a false sense of security. It may be better to let the “wisdom of the crowd” develop its own means of vetting offerings and determining those that will or will not get funded.The restriction on portals providing “investment advice” should include expanded “safe harbors” for portal filtering of offerings. As proposed, portals only may filter offerings for compliance with objective criteria (e.g., geographic or industry sector) and to exclude those that have strong indicia of fraud or raise broad investor protection concerns. The safe harbor for portal filtering of offerings should be expanded to permit exclusion of offerings as to which the portal has a strong conviction of failure.Funding portals and their principals and employees face potential “issuer” liability for misstatements or omissions made by the issuing companies on their platform. This potential liability would require portals to engage in time-consuming, expensive and inexact due diligence processes and may have an adverse selection effect, discouraging conservative portals and encouraging those more willing to take risks. A sound approach may be to expressly exempt portals from issuer liability for their issuers' material misstatements or omissions, unless the portal itself is complicit in those misstatements or omissions.The financial reporting requirements of the proposed rules may well be their most controversial. An independent accountant's review is required for raises from $100,000 to $500,000 and a full audit for those of more than $500,000. The initial and ongoing expense, particularly of an audit of a startup with no financial history, may cause a “soft cap” on offerings at $500,000 and discourage crowdfunding raises above that. A solution that will not discourage crowdfunding up to its full statutory authorization may be to dispense with an audit requirement altogether and require independent accountant reviews from $100,000 to the full $1 million authorization.With its rulemaking, the SEC has the opportunity to create a new public marketplace for equity securities. As currently proposed, the SEC rules are complex and create a number of challenging requirements for issuers and funding portals. As the commission moves forward in shaping the final rules, it would do well to not discourage their use by small businesses seeking capital through crowdfunding.

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